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Economic Substance Rules : An Overview

The UAE enacted economic substance rules on 30 April based on the EU recommendations outlined in the scoping paper issued by the EU COCG on 22 June 2018 and OECD guidance on harmful tax practices in Action 5 of the BEPS action plan.

The rules apply to companies engaged in core income generating activities (CIGA) such as banking, insurance, fund management, financing and leasing, headquarter companies, shipping business, investment holding, IP activities and distribution and service center. The scope of the new provisions includes all companies carrying out relevant activities except for any commercial company owned directly or indirectly by the UAE Government or any subordinate government authority.

To meet the economic substance requirement, companies will generally need to satisfy the following three tests:

  1. The company should be directed and managed in the UAE for the specific activity.
  2. The company’s CIGA should be performed in the UAE.
  3. The company should have an adequate level of qualified employees, premises and annual operating expenditures.

Entities may outsource CIGA activities (with the exception of “high risk” IP), provided the outsourced activities are carried out inside the UAE and the entity retains full control over those activities. In line with the EU recommendations, pure holding companies shall be subject to less stringent substance requirements. Furthermore, additional reporting requirements apply to “high-risk” IP companies.

Entities carrying on relevant activities that fall within the scope of the regulations would need to prepare a report to the regulatory authority, demonstrating that they satisfy the economic substance test, no later than 12 months after the end of each financial year. The regulatory authority will then submit the report to the competent authority, the UAE Ministry of Finance.

It is expected that further executive regulations will be issued to provide more clarifications with respect to the provisions of the new economic substance regulations, including the implementation details.

Implications

Corporate businesses, wealth management groups and family offices with any relevant activities should assess whether the economic substance laws impact their current and envisaged UAE operations. Non-compliance could result in administrative penalties for failure to meet the economic substance test (up to AED50,000 in the first financial period, and up to AED300,000 in subsequent financial periods), administrative penalties for failure to provide information (up to AED50,000), spontaneous exchange of information, and potentially deregistration.

From a wider perspective, UAE businesses should review economic substance in relation to such considerations as:

  • Access to treaty benefits in view of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS, signed by the UAE on 27 June 2018
  • International transfer pricing rules and documentation requirements
  • Application of foreign anti-avoidance rules, such as controlled foreign company rules

Affected Entities

In general, all legal entities that are resident for tax purposes in accordance with the laws of the particular noon must comply with the economic substance requirements, the only exception being if the entity is resident for tax in another jurisdiction from which a tax residency certificate must be obtained to this effect. A number of the noons have also provided particular provisions relating to the determination of tax residency in their economic substance laws.

Affected Sectors and Relevant Activities

Generally, the relevant jurisdictions have made the economic substance laws applicable to the following sectors and/or activities, namely banking, insurance, shipping, fund management, financing and leasing, headquarters, equity holding entities, head offices entities, intellectual property holding and distribution and service centers.

Economic Substance Tests

To show that sufficient economic substance exists within the noon, an entity must pass the following “substance tests”, namely that the entity must from within the noon be (i) effectively directed and managed, (ii) conduct core income generating activities, and (iii) show adequacy in respect of qualified employees, expenditure and physical presence.

Directed and Managed

For an entity to be directed and managed from within the noon it will have to show that regular board meetings are held, the required quorum of directors are present at such board meetings, that the directors have adequate experience and knowledge of such responsibilities, that the minutes of the board meetings are kept, all within the noon itself.

Core Income Generating Activities

The entity must show that core income generating activities (“CIGA’s”) are conducted within the noon with due consideration to the level of income being generated by the entity’s activities. The extent of the CIGA’s may also be dependent upon the economic sector within which the entity falls and/or the economic activity of the entity as certain entities may be an equity holding company and license intellectual property in which case it must pass the test for both activities. The important feature in complying with the CIGA’s is that the income subject to tax in the noon is “appropriate” to the CIGA’s conducted in that jurisdiction.

CIGA’s for the different economic sectors and economic activities will vary. A few examples are as follows: (i) “Equity Holding Entities” would require compliance with relevant corporate filing requirements, manage the shareholdings in the various subsidiaries with adequate personnel and an appropriate premises (ii) “Intellectual Property Holding Entities” would require research and development activities to be conducted in the noon, and (iii) in respect of intangible assets such as brands and trademarks, the CIGA’s would have to include the conduct of activities such as branding, marketing and distribution.

It is possible to outsource certain CIGA’s, even to outside the noon however this would be subject to certain conditions. In the event of outsourcing, the resources of the service provider will be taken into account when determining compliance with the required CIGA’s.

Adequacy

Relating to the two criteria mentioned above, the noon entity must have sufficient qualified employees, incur sufficient expenditure and have adequate assets within the noon in order to justify the income generated by the noon entity. The employees must be physically present in the noon, although they do not need to be directly employed by the noon entity and may be employed by another entity and may be also be employed either on a temporary or permanent basis. The determination of “adequacy” will depend entirely on the particularities of the noon entity and its economic activity.

Impact on Your Business      

Reporting Obligations

Each noon has its own reporting mechanisms however, reporting will mostly be by the submission of a bi-annual or annual “economic substance return” specifying how the substance rules are being complied by the entity. Failure to comply with the economic substance rules of the particular noon will result in the imposition of penalties or other ramifications as determined by these laws. As the implementation date of the various economic substance laws in some of the noons was 1 January 2019, the reporting obligations relating to compliance with the economic substance rules for entities incorporated prior to 1 January 2019 is as early as 1 July 2019 in some of these noons.

As part of the filing obligations to the relevant company registration offices, the noon entity will be required to submit the following details: (i) business/income types, (ii) amount and type of gross income, (iii) amount of operating expenditure, (iv) details of premises, (v) number of qualified employees, including experience levels, employment terms, qualifications and period of employment, (vi) details of CIGA’s (for each economic activity conducted), (vii) financial statements (viii) details of outsourced CIGA’s (if applicable), (ix) business plans, especially relating to reasons for holding intellectual property in the noon, and (x) evidence of quorate board meetings and resolutions passed.

Penalties for Non-Compliance

Should the economic substance requirements not be met for each financial reporting period, the noons will impose financial penalties on the noon entities and in cases of repeated violation, the noon entity may even be de-registered or placed into liquidation by the competent authorities. The amount of the penalties are determined by the economic substance laws of the noons and are not uniform. By way of example, in the BVI the Economic Substance (Companies and Limited Partnerships) Act of 2018 provides for a penalty up to USD 20,000 for the first year of non-compliance and for repeated years up to USD 400,00 per year. The impact on a local UAE entity by a holding entity is incorporated in a noon could be that unless outstanding penalties are paid, the company registration offices of the noon entity may not issue documents such as certificates of good standing and the like, that may be required for share or property transfers in the UAE, amongst other problems that may be experienced.

De-Registration and Liquidation

In the event of repeated non-compliance with the economic substance laws of a particular noon, the noon entity may be de-registered or placed into liquidation at the instance of the relevant noon’s company registration office. Should the noon entity be de-registered, this will severely impact upon the local UAE company in that, required documentation will not be obtainable from the company registration authorities in the noon as may be required from time to time in the UAE, the transfer of shares in the UAE entity will be refused, the transfer of property owned by the local UAE entity will be blocked through the lack of documents, bank accounts of the noon entity may be blocked or even closed, the agreements between the local UAE entity and the noon entity may be unenforceable or terminated, and intellectual property rights may be seriously affected.

The economic substance laws of the particular  must be complied with to avoid possibly serious implications on the operations of the UAE entity. As the reporting deadlines are close , the necessary action should be taken immediately to establish both the necessity and thereafter the requirements of the particular activities in order to comply with the economic substance rules. In the event that the economic substance laws  applicable to your business require action, immediate corrective action should be implemented to avoid unnecessary penalties. If actions have been taken, it may also be worthwhile to undergo a “health check” to ensure complete compliance.

What requirements do UAE entities need to meet?

UAE entities undertaking and earning income from a Relevant Activity must perform the related “Core Income Generating Activities” in the UAE by demonstrating that:

  1. The entity and Relevant Activity are being “directed and managed” from the UAE (through holding and minuting board meetings in the UAE, having a UAE based manager and/or directors etc.); and
  2. The entity has an adequate number of qualified employees, premises (e.g. office space), and annual operating expenditures in the UAE relative to the activity undertaken.

It is possible for an entity to carry on more than one Relevant Activity at a time, in which case the economic substance requirements will need to be satisfied for each Relevant Activity.

Different economic substance requirements apply depending on the Relevant Activity carried on. For example, pure holding companies are subject to less stringent economic substance requirements, but additional economic substance requirements apply to “high risk” IP related activities.

To understand more about the Economic Substance Regulations and determine if your entity falls within the scope of the regulations depending on your business model and activities undertaken by the business Alya Auditors tax & accounting professionals can also help you also meet the reporting requirements and implement internal reporting procedures if required.

Contact Alya Auditors & Accounting audit@alyaauditors.com 

For more details on ESR filing contact us.

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